What professional investors watch for in earnings season

Stewart Oldfield

Jul 31, 2018 — 11.00pm

Professional investors are clearing their desks and sharpening their pencils ahead of the onslaught of the 2018 reporting season.

Over a period of about six weeks managers will first pore over published data, then participate in follow-up result conference calls and finally meet with the management of hundreds of different companies.

It's a crucial time of year for fund managers. If a company's profit result is a "beat" or a "miss" of market consensus – even by just a few percentage points – it is capable of triggering a double-digit share price move.

High on the list of red flags for Yarra Capital's Katie Hudson's is management hubris. Arsineh Houspian

There are estimates of up to 70 per cent of a stock's annual share price outperformance being generated around reporting periods.

After examining the headline numbers, fund managers have to be alert to how those numbers were produced – for instance whether they were artificially inflated by the capitalisation of expenses or past restructuring charges. They must also compare the profit and loss report with the generation of actual cash during the same period because cash balances are more difficult to manipulate.

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As always, a crucial piece of information to a share price's prospects will be any profit guidance for the year ahead, if indeed it is provided.

But beyond the numbers, active investors must remain alert to a myriad of qualitative factors that can hint at the longer-term performance of a listed company and its shares.

At the highest level, the quality of management is clearly one of the biggest drivers. Conversely, investors are constantly on the lookout for factors that might indicate that a company is losing its way.

These so-called red flags are varied, some of them legend.

Matthew Kidman says the way management behaves during meetings with investors can be telling. Louie Douvis

On the desks of each analyst at one major Australian equities investment house is pinned a list of such red flags. Prominent on the list is when a listed company experiences post-result share sales by company insiders.

Some of the more commonly-cited red flags are key executive departures, out-of-step acquisitions and changes to a company's auditor.

Katie Hudson, portfolio manager and head of Australian equities research at Yarra Capital Management, says her team will be on "red" alert.

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"We will be watching for red flags through reporting season because we will be spending a lot of time with company management. They can be early signals to us of things that might be slipping."

Fundies say expensive cars are less of a red flag than an indication that an executive is doing well. iStockphoto

High on the list of red flags for Ms Hudson's team is management hubris, where a high-profile CEO might be over-confident about the prospects for his or her company. Typically, these managers don't like to be challenged about their decision-making processes or remuneration structure.

"There can be such high self-belief in some management teams that the board and shareholders often stop questioning their decision making," Ms Hudson adds.

Another red flag can be the announcement of the rollout of a new technology platform across a company.

"Nine out of 10 times there is a hiccup with supply, working capital or product delivery," Ms Hudson adds. "That's one that we have seen so many times cause big problems. They tend to be transitory but quite painful."

NAOS Asset Management chief investment officer Sebastian Evans says he likes to compare new company presentations with previous versions to see what slides or information have been omitted.

"It can tell you that implementation-wise, something might be amiss," he adds. "Sometimes they put something in just so they have something to talk about rather than what is really going on in a business."

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He also keeps alert to whether senior managers have established good rapport with rank and file staff as a sign of the health of a company's culture.

"Some people know the names of everyone's kids, other people have no idea," he adds.

Centennial Asset Management portfolio manager Matthew Kidman, who is preparing for his 40th reporting period as a professional manager, says he sometimes likes to ask the same key performance questions of company management each reporting period to see how the answers differ over time.

"You like consistency of answers," he adds.

Mr Kidman says the way management behaves during meetings with investors can also be telling.

"You obviously don't like people who are aggressive to their own staff or the outside world – that doesn't sit well. Or if they are having two or three wines on the roadshow, it suggests to me that they are not taking the roadshow seriously or might be stressed."

A high-profile sponsorship of a football team can also be a red flag.

"Sponsorships are OK if you are a brand-name and it's a relatively cheap way to get a brand up but if you are a wholesaling company or business to business, what's the use?"

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The way executives present themselves can also raise concerns.

"How people dress is pretty important. It shouldn't be but it is in the corporate world. I don't like hankies in the top pocket, I don't like rings on the little finger, I don't like long hair tied back. Not because I don't like it but it kind of makes you think why is that the case when everyone else in the corporate world doesn't do that?"

Such visual cues can cause investors to have second thoughts.

"You walk away thinking I don't feel comfortable. It makes you look at the numbers a little more closely."

He says some of these presentation and behavioural red flags are more common among small cap stocks.

"Big companies are probably less volatile in both financial terms and in people terms. If you get to the top of a big company, things have been weeded out of you. It might mean you have lost your entrepreneurial flair."

But he is sceptical of some other commonly-cited red flags.

"I don't mind flashy cars. Paul Little buying a Porsche when he was running Toll (Holdings). I don't mind that. He started the business, he grew it, it tells me that he is doing well."